Q: I’ve been hearing a lot about ESG funds and ESG investing lately. What does it mean, and why is there so much talk about it right now?
A: ESG investing refers to the practice of making investment decisions based on specific factors that measure a company’s behavior. The acronym ESG stands for “Environmental, Social, and Governance,” with each letter defining a set of standards a company must meet to be considered socially conscious. The rating, which is designated by a third-party agency or provider, allows investors to be selective with the companies they invest in. Let’s take a quick look at the issues each of these categories accounts for:
Environmental
An ESG rating reflects a company’s effect on the environment (both direct and indirect), considering the following areas of concern:
- Carbon emissions and air pollution
- Water usage and water pollution
- Energy use
- Toxic/hazardous waste
- Compliance with environmental regulations
Social
The social category of the ESG framework refers to a company’s internal relationships (with employees) as well as its external relationships (with customers, business partners, and the community). The screening is based on the following criteria:
- Racial justice, diversity, and inclusion
- Employee benefits and policies; fair pay
- Human rights
- Safety
- Data security
- Customer satisfaction
- Community outreach
Governance
Under “governance,” ESG rating agencies look at a company’s way of doing business, evaluating their procedures for transparency and ethicality. Specifically, they’re checking into:
- Diversity of leadership
- Internal checks and balances
- Executive and board member compensation
- Political contributions or lobbying
- Lawsuits, corruption, audits
Investors have become more aware of these factors and the effect that companies can have on their local communities and on the nation. For some investors, it is also important to invest in mutual funds or ETFs that are running these screens on companies before buying them.
Due to this increase in awareness, ESG funds have grown in popularity in recent years. Investment firms like Morningstar and MSCI have produced ESG rating scales or grades that apply to funds themselves (as opposed to single companies)—scores that can help you review and compare options. Usually, a socially conscious mutual fund or ETF includes “ESG” in its name, and you can also review the fund’s prospectus to understand how the investment strategy applies ESG criteria.
Still, these types of funds may suit some investors and not others. It’s always a good idea to review a fund’s strategies be sure they’re aligned with your own long-term investing goals—and to check with your adviser to determine how an ESG fund plays into your overall investment strategy.
